Investors can earn relatively attractive yields in the investment-grade corporate bond market today. Despite the poor performance since the start of the year and the likelihood of more rate hikes by the Federal Reserve, we believe investors should consider corporate bond investments now to take advantage of this year’s rise in yields. Here are four reasons why:
1. Yields are still near their 12-year highs. Corporate bond yields have risen along with U.S. Treasury yields, and then some. Corporate bond yields are composed of U.S. Treasury yields plus a spread meant to compensate investors for the additional risks that corporate bonds offer, like the risk of default.
Investment-grade corporate bond spreads have risen along with Treasury yields, pulling the average corporate bond yield even higher. With this year’s rise, corporate bond yields are near their post-financial crisis highs.
Corporate bond yields are near their 12-year high
Source: Bloomberg, using weekly data as of 8/23/2022.
Bloomberg U.S. Corporate Bond Index (LUACTRUU Index). Yield-to-worst is the lowest potential rate of return for a bond. The lower of yield-to-call or yield-to-maturity. Past performance is no guarantee of future results.
2. The corporate bond yield curve is positively sloped. The same can't be said for U.S. Treasuries. When the yield curve is positively sloped, yields for longer-term bonds are higher than the yields for short-term bonds. After all, investors should be compensated with higher yields for taking on additional interest rate risk, but that's not the case today with most Treasury yields.
Put differently, corporate bond investors are rewarded with higher yields when investing in intermediate- and long-term bonds. With U.S. Treasuries, yields decline from two years through 10 years, as the chart below illustrates.
The investment-grade corporate bond curve is positively sloped
Source: Bloomberg, as 8/23/2022.
USD US Corporate IG BVAL Yield Curve (BVSC0076) and US Treasury Actives Curve. Past performance is no guarantee of future results.
The yield-to-worst line chart above showing the recent history of the corporate bond index doesn't account for underlying maturities—it's the average of all maturities. But we know with bond investing, maturities matter. We suggest investors align their bond holdings with their investing time frame and objectives.
We've been suggesting investors modestly extend the average duration of their bond holdings for a few months now. For Treasuries, that guidance might be difficult to swallow since that means locking in lower yields than what's available in one- and two-year Treasuries, for example. But that's not the case with investment-grade corporates, as the chart below illustrates. Keep in mind that corporate bonds do come with more risks, of course.
Investors who have been waiting for yields to rise should consider moving a little further out on the corporate bond yield curve to lock in those high yields now.
Intermediate- and long-term corporate bond yields are higher than short-term corporate bond yields
Source: Bloomberg, as of 8/23/2022.
Columns represent the maturity-specified sub-indexes of the Bloomberg U.S. Corporate Bond Index (LUACTRUU Index) and the Bloomberg U.S. Treasury Index (LUATTRUU Index). Past performance is no guarantee of future results.
3. Investors can earn 4% or more without taking too much credit risk. We continue to suggest an "up in quality" theme this year. With recession risk on the rise, we don't suggest reaching for yield by dropping in credit quality. We generally have a positive outlook for the broad investment-grade corporate bond market, but for investors who don't want to take too much credit risk, "A" rated corporate bonds still generally appear attractive.
Credit risk is the risk that an issuer may default on a bond or that a bond could be downgraded, resulting in a drop in its price. Corporate bonds have varying degrees of credit risk—investment-grade corporate bonds should have less credit risk than sub-investment-grade corporate bonds, for example. Even within the investment-grade spectrum the risk can vary, but according to Moody's Investors Service, a bond with an "A" rating is still considered to have low credit risk, while a "BBB" rated bond is considered to have moderate credit risk.
As the chart below illustrates, "A" rated corporate bond yields are also up sharply this year, and investors can earn yields of 4% or more, on average, with maturities of seven years and beyond. For investors that don't want to lock up their funds for that long, average yields are still in the 3.75% range for three- to five-year maturities.
"A" rated corporate bond yields are also up sharply this year
Source: Bloomberg, as of 8/23/2022.
USD US Corporate A+, A, A- BVAL Yield Curve (BVSC0074 Index). Past performance is no guarantee of future results.
4. Investment-grade corporate bonds should be better positioned to withstand slower economic growth than high-yield corporate bonds. Consistent with our "up in quality" theme, we believe investment-grade corporate bonds have less risk of sharp declines than high-yield corporate bonds, should economic growth continue to slow. We believe there may be better entry points into the high-yield market down the road, and for now investors looking for higher yields should consider investment-grade corporates.
To be sure, corporate bond risk is on the rise. However, we believe it's more of a threat to the high-yield bond market. The corporate profit outlook is challenging, as aggregate corporate profits actually declined in the first quarter of this year, according to the Bureau of Economic Analysis. Labor costs on the rise, supply chain bottlenecks still an issue, and borrowing costs up sharply this year. These should all continue to weigh on high-yield bond issuers.
Activity from the credit rating agencies appear to reflect those risks. Within the investment-grade corporate bond market, upgrades continue to outpace downgrades by a relatively wide margin. From November 2021 through July 2022, upgrades accounted for more than 60% of the ratings changes each month, but that number has evened out in August 2022. Investment-grade-rated corporations tend to have stronger balance sheets and more stable cash flows. While corporate profit growth could still be challenging, a stronger balance sheet—like having ample liquid assets—should allow investment-grade-rated issuers to better ride out the storm. That doesn't mean that there is no risk of course; if "risk" assets decline later this year, investment-grade corporate bond prices could modestly decline as well. We believe the declines would be far less than what may occur with high-yield bonds, however.
For investment-grade issues, upgrades continue to outpace downgrades
Source: Bloomberg, with data from Moody's.
Monthly upgrade/downgrade actions of investment-grade rated companies from August 2021 through August 2022. August 2022 data through August 23, 2022.
High-yield corporate bonds have not enjoyed the same trend, as downgrades have been outpacing upgrades. In three of the last four months, high-yield downgrades have represented a majority of the ratings changes.
High-yield downgrades have outnumbered upgrades in three of the last four months
Source: Bloomberg, with data from Moody's.
Monthly upgrade/downgrade actions of high-yield rated companies from August 2021 through August 2022. August 2022 data through August 23, 2022.
What to consider now
Consider investment-grade corporate bonds if you're looking for higher income. Yields are near multi-year highs, and we don't expect them to rise much further despite the likelihood that the Fed will continue hiking rates through the end of the year. Although an economic slowdown may negatively impact all corporations, investment-grade corporate bonds should be better positioned than high-yield bonds in case market volatility does pick up.
To consider investment options, you can search using the ETF Screener or Mutual Fund Screener, or explore funds on the ETF Select List or Mutual Fund Select List under the Morningstar category of "Corporate Bond." You can also consider a separately managed account.
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